MONETARY POLICY AND COUNTERPARTY RISK MANAGEMENT: Lessons from Banque de France operations in the late 19th century
- 28 Mar 2017
Recent financial crises highlight the importance of operational procedures used by central banks to implement their monetary policy. To fulfil their mandate of financial stability and reducing financial stress, central bank actions feature temporary extraordinary loans to new types of financial intermediaries or the purchases of new types of assets.
New research by Maylis Avaro and Vincent Bignon, to be presented at the Economic History Society’s 2017 annual conference, shows how such operational procedures were also crucial in nineteenth century France in addressing the difficulties associated with implementing a discount policy in a world rigged by moral hazard.
Their study uses archives from the head office and local branches of the Banque de France to detail the procedures of supervision of the quality and wealth of counterparties. They discuss how the Banque gathered very complete pieces of information on a wide variety of counterparties – banks, other financial intermediaries and non-financial agents – and used social reputation to discriminate against the discounters. This sophisticated information system was able to protect the Banque’s profits from the risks of default by counterparties.
The authors explain the findings of their study in more detail:
Recent financial crises highlight the importance of operational procedures used by central banks to implement their monetary policy. To fulfil their mandate of financial stability and reducing financial stress, central bank actions featured temporary extraordinary loans to new types of financial intermediaries or the purchases of new types of assets.
Research has shown that those extensions of central bank operations could have mitigated the severity of financial crises (Sargent and Wallace, 1982 for theoretical evidence, and Quinn and Roberts, 2015 and Bignon and Jobst, 2017 for historical evidence). Yet those extensions have also been criticised for the lack of detailed knowledge that central banks have about their counterparties and the ensuing fiscal risk that those extraordinary measures have triggered.
Furthermore some details of these technical procedures can impede the transmission of monetary policy, notably when the absence of a system of monitoring of counterparties led to the denial of lending of last resort assistance. This argument was made by US Federal Reserve Chairman Ben Bernanke when discussing the 2008 crisis (Ball, 2016).
Our research shows how those operational procedures were also crucial in the nineteenth century in addressing the difficulties associated with implementing a discount policy in a world rigged by moral hazard, as underlined by recent banking theory (for example, Rochet and Tirole, 1996).
We use archives from the head office and local branches of the Banque de France to detail the procedures of supervision of the quality and wealth of counterparties. We discuss how the Banque gathered very complete pieces of information on a wide variety of counterparties – banks, other financial intermediaries and non-financial agents – and used social reputation to discriminate against the discounters. This sophisticated information system was able to protect its profits from the risks of default by counterparties.
We check how this system of monitoring and screening was implemented with data on 1,665 individual presenters at any of the 94 local branches in 1898 with information on their identity, occupation, economic and social situations, wealth and financial position with the Banque.
Contrary to previous research (Nishimura, 1995), we demonstrate that the Banque took no more risk with its clients as the bills they presented were guaranteed either by their own capital or by pledged securities. We find a great diversity of counterparties in terms of occupation and huge differences in terms of the type of collateral pledged between banks and non-banks.
To secure their lending with the central bank, banks relied on techniques akin to micro-finance, such as personal guarantees, while non-banks mostly pledged liquid securities. Yet we do not find any evidence of insider lending. These patterns can be understood as banks being agents providing relationship lending services in an economy in which defaults were very costly.
Contrary to the argument made by Goodhart and Capie (1994), our quantitative measures show that the Banque operated actually as the bank of banks. Financial intermediaries represented 53% of the discounters but 84% of the total discounted volume. Moreover, we find that 30% of all banks operated in France discounted at the Banque de France.
Together with the fact that the Banque was the bank of the government, this establishes its role as the central bank. This, however, leads to questioning the rationale for maintaining the discount to non-financial traders. We argue that in an economy in which screening was relationship-based between trade partners, there was no clear delineation between banks and non-banks as shadow banks operated in the middle, often as an activity that grew out of traditional merchant activity.
Ball, Lawrence (2016) ‘The Fed and Lehman Brothers’, NBER 22410.
Bignon, Vincent and Clemens Jobst (2017) ‘Economic Crises and the Eligibility for the Lender of Last Resort: Evidence from Nineteenth Century France’, CEPR Discussion Papers 11737.
Goodhart, Charles and Forrest Capie (1994) ‘The Future of Central Banking’, The Tercentenary Symposium of the Bank of England.
Nishimura, Shiyuza (1995) ‘The French Provincial Banks, the Banque de France, and Bill Finance, 1890-1913’, Economic History Review 48(3): 536-54.
Quinn, Steven and William Roberts (2015) ‘Responding to a Shadow Banking Crisis: the Lessons of 1763’, Journal of Money, Credit and Banking 47: 1149-76.
Rochet, Jean-Charles and Jean Tirole, Jean (1996) ‘Interbank Lending and Systemic Risk’, Journal of Money, Credit and Banking 28(4): 733-62.
Sargent, Thomas and Neil Wallace (1982) ‘The Real-Bills Doctrine versus the Quantity Theory: A Reconsideration’, Journal of Political Economy 90(6): 1212-36.
‘Socially embedded money creation: monetary policy and Bank of France counterparty risk management in late 19th century France’ by Maylis Avaro (Graduate Institute, Geneva) and Vincent Bignon (Banque de France)
Dr Vincent Bignon
Senior expert economist and deputy head of Microeconomic Analysis Group
Banque de France ; DGEI – DEMS – SAMIC 46-2401
31 rue Croix des Petits Champs – 75049 Paris cedex, France
Tel : 00 33 1 42 92 43 30 /00 33 6 14 12 49 96